Have you ever had the nagging suspicion that you were paying too much for an exchange traded fund (ETF)? Your fears were probably justified. This article explains how to find the real-time value of an ETF using a free resource that is frequently overlooked by many traders.

Net Asset Value

ETFs are backed by an underlying portfolio of assets. Given the recent explosion in ETF offerings, these portfolios may include a very diverse group of assets: stocks, bonds, futures, swaps, and many other types of derivative instruments. The actual value of an ETF is the total market value of its assets, divided by the total number of shares outstanding.

This concept is called a net asset value (NAV) and it originated with open-ended mutual funds. Open-ended funds typically allow transactions only once per day, at the closing NAV. As a result, all shares are purchased and sold at the NAV, which is determined using the daily closing prices of every asset in the portfolio. Unfortunately, there are many problems with this approach.

The portfolio manager must make daily purchases or sales to handle net deposits or redemptions, which generate realized capital gains and losses, which necessitate tax distributions - even for investors who did not purchase or redeem shares. Administering these daily transactions requires a significant amount of time and effort by the portfolio managers, traders, and back-office staff. As a result, fees for open-ended funds must be increased to offset these costs.

These daily purchases and sales also generate transaction costs, which are borne by all shareholders of the fund. In an attempt to discourage excessive trading and reduce transaction costs, many fund companies impose large fees on frequent round-trip or market-timing transactions.

While these fees protect the shareholders, they further reduce the liquidity of open-ended funds, which is already constrained by end-of-day transactions. As you can see, there are many problems with open-ended mutual funds, but there is one significant benefit: all transactions take place at the daily NAV. Investors in open-ended funds never overpay for the fund and always receive the fair value of the fund when redeeming shares.

ETFs Versus Open-Ended Mutual Funds

Unlike open-ended mutual finds, which only allow transactions at each day's closing NAV, ETFs trade throughout the day on one or more exchanges. That means that investors and traders may purchase or sell ETF shares at any time during the trading session.

For every ETF buyer, there is a seller and for every ETF seller, there is a buyer. This eliminates the need for ETF managers to do daily funding transactions. The size of the fund stays constant, except for in-kind transfers of assets into or out of the ETF. This directly reduces transaction costs, management fees, and capital-gains distributions. It also eliminates the need for the investment management company to impose fees on market-timing transactions. As a result, ETFs offer significant cost and flexibility advantages over typical mutual funds.

However, while ETF shares may be purchased or sold throughout the trading session, these transactions do generate transaction costs and commissions, but at least those costs are borne solely by the investors executing the trades.

However, there is an even more important issue that dwarfs transaction costs and commissions: ETF purchases and sales take place at the prevailing market price, not at the NAV. And the prevailing market price may differ greatly from the value of the underlying assets in the fund.

Real-Time Indicative Value

Real-time market prices are driven by supply and demand for an ETF. Large buy and sell orders or flocks of buyers and sellers overreacting to the ever-present forces of greed and fear can cause the price of an ETF to temporarily diverge from its actual value - sometimes by a substantial amount. The price of every asset in the ETF portfolio changes continuously and it would be impossible for us to track the value of every asset in each of our ETFs. As a result, we are always at risk of paying too much for our ETF purchases or receiving too little for our ETF sales.

Fortunately, there is a practical way to monitor the real-time value of an ETF, but very few traders use this valuable tool. Every 15 seconds, the exchanges report a real-time estimate of the ETF's fair price. This estimate is called the indicative value and is based on the most recent prices of the underlying securities. The indicative value can typically be accessed on your broker's platform by adding the suffix ".IV" to the ETF symbol.

Let's look at an intra-day chart of the actual prices of an ETF along with its indicative values. The Direxion Daily Small Cap Bull 3X ETF attempts to provide three times the daily return of the Russell 2000 index. It is a levered fund, which increases its volatility. The symbol for the Direxion Daily Small Cap Bull 3X ETF is TNA; the symbol for TNA's indicative value is TNA.IV (on Interactive Broker's trading platform).

Figure 1 below is a 5-minute chart for TNA on June 26, 2012. It also includes the first few bars on June 27, 2012. The top panel is the chart for TNA and the bottom panel is the chart for TNA.IV. The ending value for TNA was $48.20, which is highlighted in yellow on the far right-hand side of the chart. The final indicative value for TNA was $48.13. The difference was $0.07, which may not seem like much, but it represented a premium of 0.145 percent.

If you compared the two charts carefully, you would see that the relative value of TNA can swing by as much as plus or minus $0.25. This represents a return fluctuation of -0.50 percent to +0.50 percent, relative to its indicative value. If we were unlucky enough to buy at a premium of 0.50 percent and sell at a discount of -0.50%, we would lose a full 1.0 percent on our round-trip TNA transaction. By comparison, the transaction costs for buying or selling TNA would only amount to about 0.02 percent.

Figure 1: TNA indicative Value (5 - Minute Chart)

Conclusion

Many traders use mid-market limit orders and sweat over every last $0.01 when buying or selling ETFs, but completely ignore the actual value of the ETF itself. Minimizing transaction costs is important, but monitoring the real-time indicative values of ETFs will save you much more in the long run.

You do not need to chart the indicative value for every ETF you follow. Instead, for every ETF you trade, add the indicative value symbol on a separate line in your trading platform - immediately above or below the corresponding ETF. Before buying or selling, compare the market price of the ETF to its indicative value. However, always be aware that indicative values are only provided every 15 seconds. In a fast-moving market, indicative values can lag behind market prices.

I have used the term ETFs throughout this article, but indicative values are provided for many exchange traded notes (ETNs) as well. If the real-time prices are available for the underlying assets in the fund, then there is a good chance the exchange will report the indicative value

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Copyright 2012 - Trading Insights, LLC - All Rights Reserved.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers.
I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies.
In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.

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